Intrinsic value of share is the basis of value investing which is a measurement used to analyze the fair value before investing. This is completely related to the business of the company. There is a difference between the price of a share and the value of a share.
Every value investor will calculate the intrinsic value before purchasing a stock. It is not an assumption value. It has to be calculated on the figures of business output.
The price of the stocks has no coordination with the business of the company. The price is completely new and market condition-based.
There are two types of stocks 1. Overvalued 2. Undervalued. Valuation has to be done. That’s why we should be strong on our fundamental analysis
Here we will be covering to calculate intrinsic value by a few methods, graham method, buffet method, calculating the average of EPS, by financial assets of balance sheet.
1. Graham’s Formula for Intrinsic Value of Share:
Graham used to calculate the intrinsic value of share with the EPS (Earnings per share) with coordinating with the expected growth of the particular company, divided by the return of 10Y – Government bond (Currently 7.75% in India)
V =EPS x (8.5 +2g) x 4.4
V – Intrinsic Value of share
EPS – Average of last 5 years EPS (this gives us conservative value)
g – Estimated growth of the company
Y – Interest rate of 10 – Y Government bond (7.75% RBI Savings Bond)
How to calculate g (Estimated growth of the company):
The estimated growth of the company can be calculated by understanding the last 5 years of EPS. Once we find out the 5 years EPS, then calculate 5 years EPS growth.
The 5 years EPS growth will be the estimated growth of the company (g)
Now, let us calculate the intrinsic value of ITC.
g – 9.13 (last 5 years EPS growth)
EPS – 9.7 (Avg of 5 years EPS)
Y – 7.5% (Government bond yield)
So, the Intrinsic Value of share will be, V5 Y AVG= 152.28.
In my previous topics I have mentioned, intrinsic value has an interval (value range). So we will be calculating the range by 5 year average EPS and last year’s EPS. We have found the value of 5 years average, now let us calculate the current EPS value
g – 10 (Growth on EPS from 2019 to 2020)
EPS – 12.45
Y – 7.5%
So, the Intrinsic Value will be. VCurrent= 208.16.
The intrinsic Value of share range will between VCurrent to V5 Y AVG, i.e. 208.16 – 152.28
This is calculated using Graham’s Formula. we can also use a calculator the following link. Graham’s Calculator
2. Buffet’s Way Of Calculating Intrinsic Value of Share:
Buffet’s way of calculation is similar to graham’s calculation. The only difference here is, “Margin of Safety”
What is the Margin of safety?
Margin of safety is considered to be a safety proportion like 10-30% we reserve to buy any stock with the intrinsic value. We calculate the margin of safety because we will not be assured of the external cause of the company. Which lead the company to degrown in EPS or profit. This is why we should calculate MOS.
INTRINSIC VALUE = GRAHAM’S CALCULATOR – MOS
Let us take, MOS as 10% for ITC. Other stocks that have high P/E can consider up to 30%.
VCurrent = (208.16 – 10%) = 187.34
V5 Y AVG = (152.28 – 10%) = 137.05
So the intrinsic value with a 10% margin of safety being with the interval of 187.34 to 137.05.
This means when ITC comes under 187.34 to 137.05 this will be an attractive price to buy. If it goes beyond 137.05, it will be a very attractive price.
Use the following link for the Intrinsic Value calculator.
3. Calculation Using EPS:
Unlike the formula used in Graham’s calculation, this calculation is more simple and easy to find the range of a stock to buy.
We have to take the average 5 year’s EPS of stock and calculate the price of the stock using the P/E method in the range of 12-16, which is attractive to buy the stock.
Let us calculate the value range for Infosys,
The 5 years Avg EPS = 36.7
So Price at P/E 12 = 440
And Price at P/E 16 = 587.2
So, the price value of Infosys defined by attractive P/E value will be 440-587.2
4. Calculation Using Income Statement And Balance Sheet:
This is a method to analyze the intrinsic value of a stock by liquidate cash in companies hand, the main aim of this calculation is to find out Excess cash per share and Earning Value of the stock.
Intrinsic Value = Earning value of the Stock + Excess Cash per share
Earning Value of the Share:
This will be the calculation based on the income statement. From the income statement, we have to choose only the EPS. So, Earning Value of the stock is considered to be EPS divided by the Expected return
Earning Value of the stock = EPS (TTM) / Expected return.
Let us do a calculation for the same ITC on the expected return of 7.5% and 10%. EPS of 2020 is 12.45
So, the Earning Value of the stock for ITC will be of range 124.5 to 166.50
Excess Cash Per Share:
This is calculated by the balance sheet, the calculation should be more conservative and only on the cash or profit flow which is easily liquidating. In terms of liabilities consider the complete liability component.
Let us move towards the ITC Balance sheet of 2020. Page 164.
In which there are two types of Assets, Non-Current Assets (Fixed Assets) and Current Assets.
In these two categories, we have to only calculate “Financial Assets”. In Financial Assets, exclude the components like loans, trade receivables. These components are not cashed in hand.
So, with reference to the balance sheet,
(A) Non- Current Asset (Fixed Asset) = Investments + Others
= 13455.5 + 607.09
= 14062.68 cr
(B) Current Assets = Investments + Cash& Cash Equivalent + Other bank balance
= 24018.7 cr
(C)Total Assets (A+B) = 38081.38
(D) Total Liabilities = Current liabilities + Fixed Liabilities
= 2116.79 + 9089.41
= 11206.2 Cr
(E) EARNING VALUE OF COMPANY (C-D) = Total Assets – Total Liabilities
= 38081.7 – 11206.2
= 26875.38 Cr
(F) Total Number of Equity Shares = 1229.52 Cr
EARNING VALUE OF COMPANY PER SHARE = E/F
So, we have calculated the earning value per share is 21.85.
Now, we will go back to calculate Intrinsic value,
Intrinsic value = Earning Value of a stock + Earning Value per share
= 166 + 21.85 = 187.85 (Upper Limit)
So, the intrinsic value of the ITC will be of range 187.85 – 146.65
From the above four types of calculations, we have found out the calculation using Buffets method and Calculation based on the balance sheet and Income sheet seems to be similar of range from 140 – 187 is the intrinsic value.
· Intrinsic value of share is the most important before investing.
· Value of the stock is calculated by the business of the company and not by the price at which we trade.
· We can use all four methods to calculate the intrinsic value of share. Choose the average of all four values.
· Between the ranges of intrinsic value, we can buy a stock to become an intelligent investor.